National Journal's CongressDaily
February 23, 2010 Tuesday
AM Edition
Obama Health Plan Contains S Corporation Carve-Out
by Peter Cohn
President Obama's $950 billion healthcare reform plan released Monday exempts income derived from running a small, closely held business from a proposed new payroll tax on investments.
The carve-out is a concession to a range of business groups and advocates for the self-employed. But critics charge it could open the floodgates to a raft of companies re-structuring their businesses as subchapter S corporations in order to avoid the tax.
To help pay for his healthcare plan, Obama would raise the portion of the Medicare payroll tax paid by employees earning more than $200,000 a year, or $250,000 in household income, to 2.35 percent. That 0.9 percent bump would be supplemented by applying the existing 2.9 percent payroll tax -- split evenly between employers and employees -- to unearned income, defined as capital gains, interest, dividends, annuities, royalties and rents. The tax would also apply to the upper-income category.
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Unlike previous iterations of the plan, such as one advocated by the progressive group Citizens for Tax Justice, the Obama proposal exempts active income earned from shares in an S corporation, which are generally small, privately owned firms.
Critics argue structuring a firm as an S corporation enables shareholders to avoid paying Social Security and Medicare payroll taxes. One famous example is that of former Sen.John Edwards, D-N.C., whose fees from work as a trial attorney ran into the tens of millions of dollars, but he only paid payroll taxes on the much smaller portion of his income derived from wages.
The Obama plan draws on an earlier Senate plan to hike the employer portion of the Medicare payroll tax on wages. Congressional tax staff later determined that would lead to many businesses simply converting to S corporation status, thus converting their salaries into dividends, to skirt the tax. That in part drove a re-thinking of the tax to also apply it to unearned income.
After the small business lobby weighed in against the tax, Senate staff floated the idea of exempting active participation in S corporations, arguing taxing that income would hinder job-creation and investment. Twenty trade groups ranging from the American Council of Engineering Companies to the U.S. Chamber of Commerce wrote to congressional leaders Jan. 28 urging them to reconsider the tax altogether.
Under the Obama proposal, only passive investment income associated with an S corporation, such as dividends and interest from stock and bond holdings, would be subject to the tax, as well as the income of non-active shareholders. Income from active participation in such a business, which the IRS defines as "making decisions involving the operation or management of the activity, performing services for the activity, and hiring and discharging employees," would not be taxed.
"Factors that indicate a lack of active participation include lack of control in managing and operating the activity, having authority only to discharge the manager of the activity, and having a manager of the activity who is an independent contractor rather than an employee," the IRS guidance continues. The determination can be subjective, however, as the IRS notes that active participation "depends on all the facts and circumstances."
Industry officials said the Obama plan contains some inconsistencies. For example, passive S corporation shareholders who earn more than $200,000 at another job could be hit with up to 3.8 percent added tax, after factoring in the 0.9 percent payroll tax increase on wages combined with the 2.9 percent tax on investment. At the same time, an active S corporation shareholder making more than $200,000 would only pay the 0.9 percent tax on wages.
Officials said that would unfairly penalize passive shareholders, since income from that S corporation by definition could not be considered wages -- and thus could not be construed as avoiding the payroll tax.